Wednesday, January 5, 2011

Time to Read "Less Than Zero"

By chance I came across two articles today that are wildly optimistic about global economic growth in the future. First, via Karl Smith I see that Robin Hanson is talking up the possibility of a robot-induced "singularity" in the future that will radically increase global economic growth rates. Second, Ambrose Evans-Pritchard is highlighting an HSBC report that foresees a pronounced increased in the trend global economic growth by 2050.

These two pieces are both interesting but ignore an important question: what type of monetary policy arrangement would be most conducive to maintaining economic stability during such rapid economic growth? Such an environment could easily lead to overoptimism that in turn could fuel an unsustainable asset and credit boom. It is easy to see how monetary policy could play into such an unsustainable boom. The rapid productivity gains implied by these two pieces would create strong deflationary pressures. Central banks targeting some form of price stability would react by adding monetary stimulus to prevent deflation from emerging. But adding monetary stimulus in the midst of such a boom would only intensify it. Another way of seeing this is to realize that a productivity boom typically puts upward pressure on the neutral real interest rate. Trying to maintain price stability in face of productivity boom, however, requires central banks to lower the real interest rate.

So is there a monetary policy that could handle such rapid economic growth without destabilizing it? Fortunately, George Selgin has thought extensively about this very situation and has come up with what he calls the Productivity Norm Rule for monetary policy. This monetary policy rule would have have nominal GDP grow at the same rate as that of factor inputs. Doing so would allow productivity gains to be reflected in the price level while maintaining factor price stability. Thus, the Productivity Norm in an environment of rapid productivity growth would tend to stabilize nominal wages, allow the price level to decline, and yet keep aggregate spending growth stable. Selgin has nicely articulated the details and implications of the Productivity Norm Rule in his monograph titled "Less Than Zero." If, in fact, Robin Hanson and HSBC are correct in their assessment of future economic growth, then Selgin's monograph should become required reading for every central banker.

3 comments:

I think you need to build in a certain amount of nominal wage growth for "greasing the wheels" reasons. That is, since wages in different markets all experience downward rigidity, but relative equilibrium wages are always changing, there are always going to be markets where wages are too high, unless aggregate equilibrium nominal wages are rising sufficiently quickly.

This has a couple of implications. First, under any plausible rate of productivity growth, a negative inflation rate is almost certainly a bad idea. Nominal GDP needs to grow considerably faster than the rate of growth of factor inputs in order to avoid unnecessary unemployment.

Second, the target nominal GDP growth rate should compensate for changes in the price of flexibly-priced factors. I haven't really thought about how this applies to capital, but the more obvious application in my mind is to raw materials. If raw material prices are rising, then nominal GDP growth should be fast enough that wages still continue to rise at the target rate.

In an ideal world where wages are easy to measure, I would suggest just targeting aggregate nominal wages on a certain target growth path. In practice, a "crawling" productivity norm rule with an adjustment for non-labor input costs should be equivalent and might be easier to implement.

The "grease the wheels" argument is premised on money illusion: workers prefer to see nominal wage increases even if real wages are unchanged. But what if nominal wages were relatively stable and the price level was falling as under Selgin's rule? Would folks suffer from such money illusion then? If they saw their wage's purchasing power increase would they then still insist on nominal wage increases?

Along these lines, it seems such money illusion is in part the result of living in an world where inflation is the norm and increasing nominal values become expected. But what if it were not the norm? This AEA paper provides evidence from the 19th century that shows nominal wage cuts were common.

In any event, the articles I referenced above point to big jumps in the productivity growth rate. Thus, even with a higher NGDP target growth and a world with sticky nominal wages there might some mild deflation.

I wonder whether Andy Harless is prepared to pursue his argument to its logical conclusion, for that argument could easily prove in practice to serve, not merely as one for foregoing deflation, but one for tolerating inflation. Suppose, for example, that equilibrium real wage rate growth rates fall within the range of -10%-+10%. Then, according to his argument, we should have enough nominal spending growth to translate the most rapidly declining real wage rate into a constant nominal rate. If, for example, productivity is constant all around, the case in question will require a rate of income growth, and corresponding rate of inflation, of 10%. Ouch!

Perhaps Andy will reply by saying that he is content to accept the "unemployment" that must accompany such nominal equilibrium wage rate reductions as will go hand-in-hand with a low or zero (but never negative) inflation target. Very well. But then he must have some independent criterion by which he determines the "optimal" (but no longer zero) degree of wage-rigidity-based U to tolerate; and he must feel under some obligation to reveal just what that criterion is.

My own view is that monetary policy should never be aimed at addressing relative disparities. No good is served by making it necessary for the _average_ equilibrium money wage to decline. But for monetary policy to concern itself not with what is happening to the average rate but with what is happening in the lower end of the distribution is for it to proceed down the road to ruin. In the end, the argument here is the same as that which most proponents of zero inflation make for making some producers face the music of falling nominal equilibrium product prices when the relative demand for their products declines.